Whilst millennials might have raised the profile, investing responsibly is now a mainstream issue. Charities, institutions and individuals are adopting more ethical investment approaches to ensure their capital is aligned with their values – and investment managers need to meet this growing demand.

Historically, ethically minded investors simply avoided investing in deemed ‘sin’ sectors such as tobacco, alcohol, weapons, pornography and gambling. More recently, awareness of climate change has sharpened the focus on fossil fuels, with high interest rate ‘payday’ lending and obesity being two newer areas which some investors may prefer to avoid.

However, while ethical investors have chosen to avoid, exclude or ‘screen out’ certain ‘sins’, there are relatively few studies showing the impact of ‘screening out’ on investment returns. Here we look at how excluding certain sectors (‘sin screening’) over the last decade might have impacted investment returns – and what alternative approach investors can now take when concerned about the nature of their investments.


Multiple sin sector screening

At first glance, ‘sin screening’, where sectors like tobacco, alcohol, weapons and pornography are all excluded together, has barely reduced returns over the past decade for developed markets as a whole.

But look closer and there are significant geographical variations. For the UK and US, there is a more pronounced reduction in returns compared to Europe (excluding the UK) and Asia Pacific, where there is a positive impact.

Picking and choosing a combination of areas to remove can also be problematic. Excluding weapons, pornography and gambling at the same time has very little impact across geographic areas but doing the same with tobacco and alcohol has the largest negative impact on risk-adjusted performance.


Individual sin screening

Individual screens – where one thing at a time is excluded – also show significant regional variability.

Taking out one of the following five areas – tobacco, alcohol, weapons, pornography and gambling in Europe (excluding the UK) – has again a neutral impact but elsewhere there are nuances.

» Excluding alcohol in the US has a broadly neutral effect, while in the UK it benefits performance significantly

» Excluding tobacco is also neutral in the US, while conversely in the UK it has historically reduced performance.

Sector-wide screening vs materiality or threshold-based screening

It’s easy to implement a sector-wide screen in some sectors (e.g. tobacco), while others (e.g. pornography or gambling) really need a ‘materiality threshold’ to identify businesses deriving significant revenue from these activities. Think of ITV, which shows gaming content after midnight, or a network like Sky, which offers risqué channels to certain subscribers.

This means that portfolios which implement materiality or threshold-based screens exclude more of the investable universe by market capitalisation when compared with sector-wide screens.

Theoretically, the more one reduces an investable universe, the greater the impact on volatility (given the reduced opportunity set) and therefore investment returns.

Clients focused on ‘screening out’ need to understand that there are varying definitions of what ‘out’ means and there is a potential performance impact.

Screening out fossil fuels

There has been a rise in charities and institutions applying climate change related restrictions to their investment portfolio – but how does applying a fossil fuel screen impact investment performance?

For developed markets, excluding fossil fuels had no significant impact on portfolio returns in the last decade. This is surprising given oil and gas is one of the best yielding sectors. In fact, during periods of sustained fossil fuel price weakness (e.g. 2013-2016), there was a significant benefit of avoidance.

Interestingly, emerging market portfolios have generally benefited significantly by avoiding fossil fuels. Such exclusions actually increased portfolio returns and reduced volatility. This is partly related to a relatively weak decade for broad commodity prices. Many emerging market oil companies are also under state control, and not necessarily managed with shareholders’ best interests in mind.

Screening in the macro-economic context

The macro-economic backdrop, including crisis periods, will undoubtedly play an important part in the impact of screens over time. During the six months following the collapse of Lehman Brothers, ‘sin stocks’ outperformed the broader market. Why?

» During periods of growth or expansion, investors may be happy to invest in growth-oriented sectors of the market

» Conversely, during periods of depressed growth and heightened levels of uncertainty, investors may seek ‘havens’ such as sectors traditionally characterised by higher yields and greater liquidity – e.g. tobacco and oil and gas producers.

That said, these havens may start to change as smoking numbers decline and renewable energy gets cheaper.


To screen or not to screen?

Excluding sectors from your portfolio can obviously have an impact on returns. This can be positive, negative or neutral depending on what’s excluded and where. Further, the data does not show the impact of manager discretion on narrower investment mandates.

The narrower the universe of companies available, the narrower the potential ability to diversify return sources. What’s more, sinful areas often have financial advantages. Think of the resilience of tobacco sales during a recession, as well as their good corporate governance. If you decide to screen out, what matters is finding suitable substitutes to mitigate the impact of excluded areas.

However, to many ethical investors, ensuring their capital is aligned with their values is the most important thing – and sin screening is the only way they will invest, no matter the impact on their investment returns.

For other investors, they want to consider both the financial and non-financial aspects of investing – i.e. financial returns alongside their wish to invest more responsibly.


Screening in (and out) with ESG investing

ESG (environmental, social and governance) investing offers a realistic alternative to simply sin screening.

Rather than screening out a broad sector of companies, ESG investing actively ‘screens in’ companies that either already are, or are working to become, more environmentally friendly, a better employer and community member, and more transparent in the way they run their business.

At Canaccord Genuity Wealth Management, our ESG portfolios use both negative (screening out) and positive (screening in) filters to select investments, and use ESG standards in their decision-making process. Our ESG portfolios currently have zero exposure to tobacco, armaments, gambling or pornography, and many of the underlying fund managers also limit exposure to alcohol, animal testing and companies with poor environmental or human rights records. Others adopt even more stringent criteria.

While it is comforting to know that sensible portfolio exclusions can be managed with limited effects on investment returns, it is even more reassuring to know that negative screening can be combined with positive screening approaches to ensure there is a more diversified approach to investing responsibly. As a result, ESG investing tends to be more profitable than traditional ethical investing, and there is mounting evidence that companies that manage ESG issues well tend to outperform those that don’t, by a significant margin.


This article was created for the DISCUS website by Patrick Thomas, Head of ESG Investments at Canaccord Genuity Wealth Management (CGWM). If you would like to find out more about Canaccord Genuity Wealth Management, you can visit their dedicated page on this website or see how their services compare to other discretionary offerings via the DISCUS Compare tool.